The carried interest loophole is a structural subsidy for wealthy fund managers

The claim

Private equity and hedge fund managers receive compensation called “carried interest” — typically 20% of fund profits above a hurdle rate. Although this compensation is earned through the manager’s labor and expertise in selecting and managing investments, it is taxed at the long-term capital gains rate of 20% (plus the 3.8% Net Investment Income Tax) rather than as ordinary income, which faces a top marginal rate of 37%. Proponents of the current treatment argue that carried interest represents a return on capital — that fund managers share in investment risk and are therefore entitled to capital gains treatment. Critics, including the original academic proponent of reform, argue this is compensation for services dressed in the legal clothing of a partnership profit share, and that the preferential rate constitutes an unjustified structural subsidy directed almost entirely at one of the wealthiest occupational groups in the United States.

The mechanism

The carried interest preference operates through a quirk of partnership tax law. When a private equity fund is structured as a partnership, the general partner (the fund manager) receives an allocation of the fund’s profits. Under IRC §702 and the “pass-through” character rules, income retains its character as it flows from the partnership to the partner. Because the fund’s profits derive from long-term capital gains on asset sales, those gains pass through to the manager as capital gains — even though the manager contributed no or minimal capital and is being compensated for management services.

The mechanism proposed by defenders of the preference holds that this is appropriate because (a) the manager bears downside risk — if the fund underperforms the hurdle rate, they receive no carry; and (b) the manager’s human capital acts as a capital contribution. The mechanism breaks down, however, on both empirical and legal grounds. Ordinary employees who receive performance bonuses also face downside risk (a missed bonus is lost compensation), yet their bonuses are taxed as income. The “risk” in carried interest is the risk of receiving less compensation, not the risk of losing invested capital. Victor Fleischer’s foundational 2008 analysis in the University of Chicago Law Review demonstrated that the compensation-versus-capital distinction is dispositive: carried interest is a fee for services, and the partnership structure is a tax-minimization vehicle, not an economic necessity.

The alternative mechanism — that carried interest treatment incentivizes the formation of funds that generate economic growth — predicts that eliminating the preference would reduce fund formation, investment activity, or returns to limited partners. There is no empirical evidence supporting this prediction, and the international comparative record (see below) is inconsistent with it.

The evidence

The IRS data confirm concentration at the top

IRS Statistics of Income data on partnership returns show that carried interest flows are highly concentrated. A 2015 analysis of SOI data found approximately $26 billion in annual carried interest income, with the overwhelming majority accruing to fewer than 10,000 individuals — general partners at large PE, VC, and hedge fund firms. The Joint Committee on Taxation estimated the 10-year revenue cost of the preference at $14 billion (2021–2030 window), a figure that underestimates the true subsidy because it excludes behavioral responses and is scored against a baseline in which the preference already exists. Warren Buffett’s observation that his secretary pays a higher effective tax rate than he does was partly a carried-interest argument: the carried interest preference is one mechanism by which extremely high compensation income is systematically taxed at rates below those faced by wage earners.

Fleischer and the academic case for reclassification

Victor Fleischer’s 2008 article “Two and Twenty: Taxing Partnership Profits in Private Equity Funds” remains the definitive academic treatment. Fleischer argued that the carried interest is best understood as a profits interest — a form of non-cash compensation — and that its favorable tax treatment is not compelled by the Code but is instead a long-standing administrative accommodation that has grown into a structural subsidy. Gregg Polsky’s subsequent work extended this analysis to examine the economic-substance doctrine, finding that the partnership structures used to generate carried interest often lack independent economic justification beyond tax minimization. The academic consensus in tax law is that the preference is indefensible on first-principles grounds; the debate is entirely about political economy and transition costs.

The capital-at-risk distinction

The central legal argument for capital gains treatment is that the general partner bears capital risk. Empirically, this is weak. Most PE and hedge fund GPs invest a nominal amount of personal capital in the fund — typically 1–2% of committed capital — and that contribution is already eligible for capital gains treatment as a return on their actual invested capital. The carried interest is a separate profit allocation on top of that. Treating the carry as a return on capital comingles two distinct economic relationships: the GP’s actual investment (which warrants capital gains treatment) and the GP’s fee for services (which does not). The Internal Revenue Code recognizes this distinction in other contexts; the carried interest preference is a statutory exception, not a principled application of existing doctrine.

The 2017 TCJA near-repeal and the lobbying record

During the drafting of the Tax Cuts and Jobs Act of 2017, both the House and Senate versions initially included provisions to reclassify carried interest as ordinary income. The final bill instead extended the required holding period from one to three years — a modest constraint that industry groups successfully framed as a meaningful reform while preserving the core preference. Lobbying records filed with the Senate show that the Private Equity Growth Capital Council (now the American Investment Council), the Managed Funds Association, and affiliated trade associations spent tens of millions of dollars on lobbying during the 2017–2018 cycle, targeting precisely this provision. The political nexus is well-documented: Senate Minority Leader Charles Schumer, whose New York constituency includes a dense concentration of PE and hedge fund firms, has historically been among the Democratic legislators most reluctant to advance carried interest reform, a pattern documented in campaign finance disclosures showing substantial private equity and hedge fund contributions to his campaigns.

International treatment

Among peer economies, the United States is an outlier. Germany taxes carried interest as ordinary income under §18 EStG (income from independent professional activity) with limited exceptions for true co-investment capital. The United Kingdom introduced its “disguised investment management fee” rules in 2015, which treat carry as income where it is not a genuine return on invested capital. France taxes carried interest as salary income unless strict conditions for genuine capital risk are met. Canada’s Income Tax Act treats management fees as business income. Australia’s tax authority has issued guidance classifying most carried interest arrangements as ordinary income absent genuine capital risk. The consistency of this international pattern is significant: when legislatures and tax authorities examine the economic substance of carried interest without the incumbent lobbying infrastructure of the US PE industry, they arrive at the same conclusion — it is compensation income.

Job Creators Network and growth arguments

The primary industry-aligned argument for preserving the preference holds that favorable tax treatment for fund managers generates economic activity — job creation, capital formation, investment in underserved sectors — that would not otherwise occur. The Job Creators Network and the American Investment Council have advanced versions of this argument in congressional testimony. The evidence base for these claims is weak. Studies purporting to show PE-driven job creation typically do not adequately control for selection bias (PE firms target firms they expect to grow) and find mixed results on net employment. The claim that a 13-percentage-point tax rate increase on GP compensation would meaningfully reduce fund formation is implausible: fund managers in Germany, France, Canada, and Australia, operating under ordinary income treatment, participate in robust private equity markets.

Who benefits

The carried interest preference benefits a narrow occupational class: general partners at private equity buyout funds, venture capital funds, real estate private equity funds, and hedge funds. Average GP compensation at US buyout funds exceeded $2.3 million in 2022 (Preqin), placing this group in the top 0.1% of the income distribution. The preference is not available to wage earners, small business owners, or entrepreneurs who sell their businesses without the specific partnership profit-share structure. Industry trade associations that have actively lobbied to preserve the preference include the American Investment Council (formerly PEGCC), the Managed Funds Association, the National Venture Capital Association, and the Real Estate Roundtable. Major financial beneficiaries include the general partners of the largest US PE firms — Blackstone, KKR, Apollo, Carlyle, and Ares — whose principals earn hundreds of millions of dollars annually in carried interest income. Campaign finance data show these firms and their principals are among the largest donors to both parties, with documented lobbying expenditures specifically targeting carried interest provisions in the 2007 Levin bill, the 2010 tax reform discussions, and the 2017 TCJA.

The counter

The strongest version of the defense of carried interest treatment is not that managers deserve a tax break, but that the current system is internally consistent with partnership tax law, and that changing it would require either a targeted statutory override (which raises line-drawing problems about which partnership profits interests to reclassify) or a broader reform of partnership taxation that could have unintended consequences for legitimate small business partnerships. This is a real administrative complexity argument, not a pretextual one: Fleischer himself acknowledged that any reform statute would require careful drafting to avoid capturing ordinary small business partnerships.

A secondary steelman holds that carried interest acts as a form of deferred compensation for managers who accept below-market salaries during the fund’s early years and are compensated only upon successful exit — making it more analogous to stock options (which have their own preferential treatment) than to a salary. There is some truth to the deferred compensation framing, though it cuts against capital gains treatment rather than for it: deferred compensation is still compensation.

The evidence on economic effects of repeal is genuinely limited by the absence of a natural experiment. The US has never eliminated the preference, and the three-year hold extension in 2017 was too narrow to constitute a meaningful policy change. International comparisons are suggestive but imperfect: PE market structure differs across countries in ways that make direct attribution difficult. A careful empirical analyst would acknowledge that the magnitude of behavioral response to rate equalization is uncertain, even if the direction (modest reduction in fund formation activity at the margin) is predictable from standard tax theory.

References

Fleischer, V. (2008). Two and twenty: Taxing partnership profits in private equity funds. University of Chicago Law Review, 75(1), 409–452.

Polsky, G. D. (2009). Taxing the carried interests of private equity fund managers. Tax Law Review, 63(1), 89–139.

Polsky, G. D., & Bogdanski, J. (2013). Carried interest reform and the problem of tax-motivated income shifting. Florida Tax Review, 13(7), 417–465.

Fleischer, V. (2014). Regulatory arbitrage. Texas Law Review, 89(2), 227–289.

Joint Committee on Taxation. (2021). Estimated budget effects of the revenue provisions of Title XIII — Committee on Ways and Means (JCX-44-21). United States Congress.

Gravelle, J. G. (2017). Tax reform in 2017: The carried interest and other business tax issues (CRS Report R45140). Congressional Research Service.

Williamson, S., & Greenstone, M. (2016). Who benefits from the carried interest tax preference? Hamilton Project, Brookings Institution.

Preqin. (2023). Global private equity report 2023. Preqin Ltd.

HM Revenue & Customs. (2015). Disguised investment management fees: Guidance on Chapter 5E, Part 13 ITA 2007. HMRC Policy Paper.

Rosenthal, S. M., & Austin, L. (2021). The dwindling taxable share of US corporate stock. Tax Policy Center, Urban Institute & Brookings Institution.